DDBA 8541 Week 10 Exit Waterfall Analysis Example

Five Ways the Funders' Claims End: An Exit Analysis of a Freight-Matching Software Company With Seed and Series A Preferred Outstanding, Recording Who Is Paid What and Who Chose Each Ending

Student Name

Walden University

DDBA 8541: Seminar in Entrepreneurial Finance

Instructor Name

Month Day, Year

Five Ways the Funders' Claims End: An Exit Analysis of a Freight-Matching Software Company With Seed and Series A Preferred Outstanding, Recording Who Is Paid What and Who Chose Each Ending

The Capital Structure

LoadLink, a composite company in Kansas City, runs software that matches trucking capacity with shippers' loads. Its capital structure has three classes. Seed preferred: 2.0 million shares bought for $2 million, with a 1x non-participating liquidation preference. Series A preferred: 2.5 million shares bought for $10 million, with a 1x non-participating preference senior to the seed. Common: 7.5 million shares held by the two founders and employees, including vested options. On an as-converted basis, there are 12 million shares. Each preferred class, at an exit, takes either its preference or the value of its shares as converted to common, whichever is larger. All figures are illustrative.

The Settlement Table

[after]

Table 1

Payments by Class Under Five Endings

How Each Row Is Computed

In the wind-down, $0.8 million remains after creditors. The Series A, being senior, takes all of it, and the seed and common receive nothing.

In the $14 million sale, the Series A compares its $10 million preference with converting: converted, it would own 2.5 of 12 million shares, worth far less than $10 million, so it takes the preference. The seed then compares $2 million with converting into a share of the $4 million left; converted, it would receive about $0.84 million, so it takes the preference. Common receives the remaining $2 million, about 27 cents a share.

In the $60 million sale, converting beats the preference for both classes. If both convert, each share receives $5, so the Series A receives $12.5 million and the seed $10 million, more than their preferences. Neither class gains by switching back, so both convert, and common receives $37.5 million.

In the public offering, the Series A's terms convert all preferred automatically, and every share is valued at the offer price, here $12.50 a share on a $150 million value.

Who Chooses the Ending

Payment is only half of the analysis. The other half is who can force or block each ending. A wind-down requires the board's approval and, under the protective provisions, the consent of the Series A majority. A sale requires the same consent, and the drag-along clause obliges the common holders to vote for a sale the board and Series A majority approve. A public offering requires the board and, if it falls below the qualified size in the charter, Series A consent. Survival with no exit needs no one's choice; it is what happens when no one forces an ending, and the preferred holders have no redemption right to demand their money back.

Why Control Over the Ending Matters

The table shows that the Series A does best, relative to common, in the modest sale, where it takes $10 million of $14 million while holding about 21 percent of the shares. The common holders do best relative to the Series A in the large sale and the offering. A Series A holder who doubts that the company will grow may prefer an early modest sale; founders may prefer to keep going. Because the Series A holds consent rights over a sale, it can block a sale it dislikes, and the drag-along lets it, with the board, compel common holders to accept one.

Black and Gilson (1998) argued that an active market for initial public offerings supports venture capital partly because the offering lets entrepreneurs regain control from investors; automatic conversion strips the preferred holders' special rights. Their argument explains why the public offering ending matters to founders beyond its price. Kaplan and Stromberg (2003) found that venture contracts allocate control and cash flow rights separately and often make control depend on performance, which fits LoadLink's structure. Gornall and Strebulaev (2020) showed that common shares are worth less than preferred at the same headline price because of these preferences, and the table shows why: in the $14 million sale, a common share receives 27 cents while a Series A share receives $4.

Limits

The analysis ignores taxes, transaction costs, debt beyond the wind-down and management carve-outs, any of which could change the figures. It assumes the stated terms; actual documents may contain participation rights or different seniority.

References

Black, B. S., & Gilson, R. J. (1998). Venture capital and the structure of capital markets: Banks versus stock markets. Journal of Financial Economics, 47(3), 243-277. https://doi.org/10.1016/S0304-405X(97)00045-7

Gornall, W., & Strebulaev, I. A. (2020). Squaring venture capital valuations with reality. Journal of Financial Economics, 135(1), 120-143. https://doi.org/10.1016/j.jfineco.2018.04.015

Kaplan, S. N., & Stromberg, P. (2003). Financial contracting theory meets the real world: An empirical analysis of venture capital contracts. Review of Economic Studies, 70(2), 281-315. https://doi.org/10.1111/1467-937X.00245